Daily Comment (May 7, 2019)

by Bill O’Grady and Thomas Wash

Trade turmoil: So, is the tariff threat real or a bluff? Equity markets decided yesterday that it was more the latter than the former.[1] This morning, equity markets seem less convinced. This is what we know:

The U.S. is calling out China for reneging on previous agreements.[2] Lighthizer appears to have taken the lead in talks with China, edging out Treasury Secretary Mnuchin. Lighthizer, as we have noted before, is a hardliner on trade. He was instrumental in getting Japan to agree to “voluntary” auto export reductions in the late 1980s and is known as a relentless negotiator. Although President Trump seems to really want a deal, he trusts Lighthizer and the change in course likely reflects that the president agrees with his trade negotiator that China was trying to pull a fast one. It’s also important to remember that for Lighthizer these talks are perhaps his last chance to fundamentally change the U.S./China trade relationship to favor America, much like he did with the U.S./Japan relationship. Thus, he is less concerned about China’s “feelings” and the 2020 elections. It had appeared Trump was leaning toward Mnuchin and against Lighthizer so a deal could get done, but Lighthizer may have appealed to Trump’s “inner Jackson” and convinced the president that a hardline position was justified. But, come what may, Lighthizer’s goal doesn’t necessarily coincide with the president’s in all areas. If Trump decides to follow Lighthizer, a rupture in U.S./China trade relations is much more likely.

So far, China’s response has been measured. Vice Premier Liu will come to Washington, but not until Thursday and will leave the next day. He was originally scheduled to arrive on Wednesday and stay until Saturday.[3] Although the visit does avoid a complete rupture, it is hard to see how we can avoid the tariff increase.

Both sides may have overplayed their positions. The White House is basking in historically low interest rates and surprisingly strong GDP, while China is coming off a successful OBR meeting and better economic data.[4] Wars often start because the participants overestimate their own positions and underestimate their opponents.

China may have concluded that continuing to negotiate was a better outcome because elections in 2020 would likely force the U.S. to capitulate. Lighthizer likely sniffed out this position and may have recommended that the president renew the tariff threat.[5]

It is possible the White House believes that an increase in trade tensions might prompt the FOMC to cut rates. Although we are not sure that would occur, a breakdown in talks would likely weaken sentiment and may lead the Fed to ease. Thus, the president may think he has the Fed at his back if things go south.

Financial markets continue to expect a deal to be finalized. There is good reason to expect that outcome. But, it isn’t certain and there could be an equity correction looming if trade talks fail.[6]

Iran: According to reports, the U.S. received credible intelligence that Iran was planning to attack U.S. assets in the Middle East.[7] The U.S. response is something of a half measure. If the U.S. was really going to war with Iran, we would see three carrier groups in the region, not one. At the same time, the CVN Abraham Lincoln is a formidable asset and will get Iran’s attention. We suspect Iran has “fired up” Hamas and Islamic Jihad to attack Israel, leading to the recent missile strikes.[8] Iran’s problem is that the reduced U.S. exposure in the Middle East has led to a quiet alliance between the Arab states and Israel. Iran, under sanctions, is finding it difficult to respond to this pressure. Its “softest” target is Iraq, but it already has influence there anyway. Syria is a less reliable party because of Russian influence. Therefore, the desire to strike back at the Sunni Arab states makes sense. It should be noted that if Iran does “something” (e.g., cyberattack on Saudi Arabia, etc.), then the only real targets for U.S. warplanes are in Iran itself. Thus, the chances of escalation are probably increasing. However, it still is not obvious that Iran will act in such a way that makes it obvious Iran is the perpetrator. Iran is a master of the covert.

Turkey: President Erdogan’s party has forced a new municipal election in Istanbul.[9] The initial vote was allegedly corrupt. We have no doubt that, compared to Western standards, the election process was probably open to question. However, our reading of the process suggests there was nothing all that unusual in last month’s local elections. New elections will be held on June 23.[10] It appears Erdogan is unwilling to accept adverse results and that is unnerving foreign investors.[11] The TRY has weakened on the news; however, our position is that the currency has already discounted significant bad news.

Brexit: Although there is hope that May and Corbyn can put together a coalition to approve a customs union, this outcome may not have staying power. It appears that even if a deal is made we are probably still looking at either a new referendum[12] or new general elections.[13] It isn’t clear that a new referendum will offer any more clarity and the second outcome probably either leads to a Corbyn government (and market panic) or Johnson (panic, but less so). Stay tuned…

Fed governors:Senate GOP leaders are putting together a list of potential governor candidates for the White House to avoid a repeat of the Stephen Moore/Herman Cain situation.[14] Although this makes sense, the candidates offered will likely be hard money policy hawks, exactly the opposite of what the president wants. So, we expect no short-term resolution on this issue.

These reports were prepared by Confluence Investment Management LLC and reflect the current opinion of the authors. Opinions expressed are current as of the date shown and are based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security. Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. Investments or strategies discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances.

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